Race to the bottom on ETF fees benefits investors

BOSTON -- There's a price war brewing. Exchange-traded funds are becoming cheaper by the month and cost-conscious investors are reaping the rewards. That's provided they don't focus so narrowly on expenses that they disregard other factors, like which investments to select in the first place.

The largest ETF provider, BlackRock's iShares unit, recently said that it's finalizing ETF fee cuts that will be detailed later this year. Charles Schwab slashed its ETF expenses last week.

Other big ETF players could follow suit, further pressuring mutual funds to cut expenses to avoid losing more investors and assets to the fast-growing ETF industry.

ETFs are on track to record a sixth-consecutive year of attracting more than $100 billion in new cash. Although ETFs held about $1.2 trillion at the end of July, mutual fund assets are still about 10 times larger.

The cuts at Charles Schwab enable investors to pay just 40 cents a year for every $1,000 in a diversified stock ETF. The two lowest-cost ETFs among Schwab's lineup -- U.S. Broad Market (SCHB) and U.S. Large-Cap (SCHX) -- now have expense ratios of 0.04 percent. That's the ongoing charge to cover operations costs, expressed as a percentage of assets.

Index mutual funds have long been the first choice for anyone looking to invest on the cheap, but they're now being undercut by the lowest-cost ETFs. For example, Vanguard's lowest-cost stock mutual fund available to average investors, the 500 Index Fund (VFIAX), charges a shade above the cheapest Schwab ETFs. It charges 0.05 percent, with a minimum investment of $10,000.

IShares could soon shift the cost equation further in favor of ETFs. BlackRock's CEO recently said that his company plans to announce cuts at some of iShares' largest stock ETFs later this year.

IShares, State Street's SPDRs family of ETFs and Vanguard commanded a cumulative 84 percent of the U.S. ETF market last month, based on assets managed, according to the research firm ETFGI. IShares was the leader with a nearly 44 percent share. Schwab ranked 12th, with a share of 0.7 percent.

"(Schwab is) trying to move up among the top five or 10 ETF providers," says Todd Rosenbluth, an ETF analyst with S&P Capital IQ. "To do that, they need to draw appropriate attention, and shoulder some of the costs themselves by cutting fees this low."

The ongoing fee reductions have put some ETF providers at risk of failing to fully recoup costs. Schwab CEO Walt Bettinger says his company's cuts should be viewed as part of a broader strategy to offer low-cost options across a range of investments.

Most ETFs are similar to index mutual funds. Both seek to match rather than beat the market by investing in a basket of stocks or bonds. Fees are typically low because investors aren't paying managers to pick investments.

A distinct feature is that ETFs can be traded throughout the day like stocks, unlike mutual funds that are priced only at the close of daily trading. Also, with ETFs, average investors pay the same expenses as institutional investors, unlike with mutual funds. But fees shouldn't be the sole consideration in comparing ETFs, or mutual funds. Here are some factors to keep in mind.

Know what you're investing in

Many of the more than 1,000 ETFs available invest in narrow segments of the stock market, and some hold just a dozen or so stocks. They're primarily used by institutional investors looking to put money in a small market segment. If you're investing for retirement, you're likely to be better off with a diversified ETF investing broadly across the stock or bond market.

Look under the hood

Diversified stock ETFs aren't all the same. While many track the Standard & Poor's 500 index, others invest in broader or narrow market segments. For example, Schwab's Large-Cap ETF tracks an index of 750 U.S. stocks, so it includes hundreds of stocks that are too small to be in the S&P 500. If those smaller stocks under- or outperform the S&P 500, the resulting performance difference in the ETF could overwhelm any advantage afforded by choosing an ETF with lower fees.

Give it a little time

Rosenbluth says Schwab's attempt to gain market share has been hampered by the fact that its stock ETFs are still too new to have 3-year performance records. Schwab launched its first ETF in November 2009. Many investors are reluctant to consider investing in a fund that isn't well-established, and doesn't offer much of a history for assessing performance.

"For many people," Rosenbluth says, "the 3-year benchmark is a starting point for their decision-making."

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